Soft budget constraints: The case of municipal bonds in Italy

This paper discusses a novel approach to identify soft budget constraint expectations,\r\nexploiting the idea that financial investors rationally incorporate in sub-national bond\r\nprices also expectations of future bailouts by the central government. We consider as a\r\ntesting ground the municipal bond market in Italy. We first build an original dataset of all\r\nthe 1 388 bond issuances from 1996 (the year when the national legislation provided an\r\norganic discipline for municipal bonds) to 2011, involving 529 cities out of about 8 000.\r\nWe then regress bond yields at issuance on bond characteristics, central government\r\nbond yields, and three proxies for bailout expectations on soft budget constraints (an\r\nindex of vertical fiscal imbalance and of central government budget tightness, plus a\r\ndummy for the city being subject to the Domestic Stability Pact). Our results suggest that\r\nsoft budget constraint problems arise frequently, especially in small cities and those\r\nlocated in the poorer South.